1031 Exchange Primary Residence
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“A 1031 exchange has become one of the most significant tax strategies for investors regarding capital gains taxes. As a result, many wonder if they can postpone capital gains tax on an investment property if the proceeds go into another investment. In short, they cannot use this strategy in their primary residence.”

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1031 Exchange Primary Residence

Fortunately, some exceptions may apply in some situations. It can benefit homeowners to understand the requirements and rules of 1031 Exchange Primary Residence to make informed decisions regarding their investment portfolios and for tax planning. So let’s get started.

 

1031 Exchanges: What Are They?

Investing in investment properties can result in deferred capital gains taxes; investors can save tremendously on tax bills. Leveraging also enables investors to upgrade to a larger or better-performing property. This is an excellent investment strategy to diversify your portfolio or choose easier-to-manage properties, such as triple-net leases.

It is possible, however, to use a 1031 exchange for personal properties on purpose, including one method for deferring federal capital gains taxes on a residence.

 

1031 Exchange: How it works?

Investors can defer paying capital gains tax when they exchange one like-kind property for another under IRC Section 1031.

Traditional tax-deferred exchanges follow the following 1031 exchange rules primary residence:

  1. Neither the relinquished nor the replacement property can be of the same kind.
  2. Investment or business purposes are necessary for real estate.
  3. The replacement property must have a value equal to or greater than the property relinquished
  4. Investors cannot receive boot payments in cash or cash-like benefits.
  5. Titles on replacement properties must match those on relinquished properties.
  6. Within 45 days of the sale, one must identify a replacement property.
  7. To replace the relinquished property, purchase a new one within 180 days.

If you live in your primary residence, you cannot conduct a 1031 exchange with it. That’s because your primary residence does not serve as a place for business purposes or an investment property. Your primary residence serves as a family’s home.

However, conducting a 1031 exchange using your primary house under IRC Section 121 of the Internal Revenue Code is possible.

 

A Guide to 1031 Exchanges on Personal Residences

What is 1031 exchange personal residence? Since a primary residence is not commercial, the IRS generally does not accept 1031 exchanges. It is provided under the Internal Revenue Code (IRC) that there are certain conditions under which a 1031 exchange may be allowed. Here’s how it works.

 

Do 1031 Exchange Properties Allow Residents To Live There?

The 1031 exchange property you are exchanging cannot live in at the exchange time. Let’s clarify that.

As per Section 121 of the Internal Revenue Code, if an investor owns the property for at least five years and lives there for two out of those five years. They can exempt capital gains tax from it through a 1031 exchange. To qualify for the exchange, you must prove to the IRS that you rented the property at market rates and used it for business while living elsewhere.

 

Performing a 1031 on Your Primary Residence: An Example

Can 1031 exchange be used for primary residence? For a former primary residence sale, you can take a gain of $250k/$500k tax-free. Please consult a tax specialist or CPA for more information about your situation. A 1031 primary residence would defer capital gains taxes above that amount, as any gains above that amount would be taxable.

  • My apartment complex has five units, and I have lived in one unit for two of those years.
  • After buying the property for $1M ($ 200 K per unit), I eventually sold it for $2M ($ 400 K per unit).
  • Because the unit I used as a primary residence is below the $500k threshold ($400k), I was able to avoid paying taxes on it. Still, I could not perform 1031 for the rest of the money, but for the remaining $1.6M, I could buy other investment properties with the proceeds.

 

To live in one house for a while

It’s a good idea to live in one house for a while and then move into a second one, renting out the first one if you own more than one house. Since the IRS allows only one primary residence at a time, you can convert the first house into a rental if your primary residence changes.

The 1031 exchange for primary residence allows you to convert a rental property into a primary residence. It is also possible to perform a 1031 exchange on a personal residence by doing the opposite of what we have discussed previously.

You may be able to exchange a rental property for a primary residence and benefit from a 1031 exchange with the IRS. Rent out the property for at least 24 months, and you have not lived in it for more than fourteen days out of every 12 months to qualify for this.

 

Airbnb rentals or VRBO rentals

Additionally, it can apply to properties that serve as Airbnb rentals or VRBO rentals. It is referred to as “qualified use” by many investors. It often applies to a secondary vacation home that rents. The owners live in their primary residence for most of the year.

This requires that you demonstrate to the IRS that rental rates were at market rates. During this period, you cannot make any custom changes to the rental for your use. This includes advertising the rental and showing how much a similar property would cost.

 

1031 Exchange Property Conversion Tips

1031 exchange rental property to primary residence can be wise if you plan to downsize or move with lower costs. If you purchased the rental property through a 1031 exchange, you may still be able to convert it into your residence after following specific steps.

 

1031 Exchange Property Conversion Tips

 

The 1031 exchange requires that the property you relinquish and the one you acquire serve for productive business or investment. Your intention when you acquire the replacement property is also crucial.

If, for example, you bought it for business purposes, but suddenly, circumstances change, and you start using it for personal purposes, you would be considered qualified for a 1031 exchange. If you own your 1031 for the required period, it may be possible for you to convert it to your principal residence without paying capital gains taxes.

 

The Best Way to Convert 1031 Exchange Property into a Principal Residence

In some cases, renting might be the best way to downsize or relocate to an area where the cost of living is lower. If you acquired the rental property through a 1031 exchange, you could still make it your primary residence by following a few rules.

As part of a 1031 exchange for qualified purposes, you must use the properties you relinquish and those you get in productive business or investment. You must also know your intentions when you acquire the replacement property.

If, for example, you purchased the property honestly for business purposes, such as renting, circumstances change, and you start using it for personal purposes. As long as you own your 1031 for the required period, you may not have to pay capital gains taxes on the conversion.

As a rule of thumb, you may need to prove that you did not move into the property immediately for your use, such as by making it your vacation home once closing but intended to use it as an investment.

 

A rental property purchased through the exchange of a 1031

You must hold a rental property acquired through a 1031 exchange for the safe harbor test for at least three years before turning it into a principal residence under the IRS’ safe harbor test.

To demonstrate intent through the safe harbor test, make sure to follow these best practices:

  • Your replacement property sale contract should not contain a contingency for selling your old property.
  • After purchasing the property, do not begin construction on it for personal use.
  • Describe how you determined your property’s rent price.
  • You should keep copies of rental property listings and advertisements at a fair market value.
  • Moving into the house immediately after closing is not a good idea, even temporarily.
  • Around the time of the exchange, don’t prepare plans for the property to become a vacation home or primary residence.
  • If you intend to move into the property, do not announce it prematurely.
  • Include any relevant paperwork or legal files when you become eligible to use the property as a primary residence.
  • Ensure you save the contact information of potential tenants interested in renting your property.
  • Condos, apartments, and rentable properties are good options for replacement properties.

 

Documentation

To conduct a 1031 exchange, you must consider these fundamental factors. Suppose you need to provide documentation or call on witnesses to prove that when you acquired the property, you intended to use it for business. In that case, they can save your exchange from being invalidated.

Alternatively, if you cannot meet the above criteria, you can invest in the property or use it for business for an extended period. The investment intent can be proven, for example, if you rent the property for at least two years.

If your monthly rent is way above market rate, the IRS may assume you’re trying to avoid renting it out. If you list it at a fair value, the IRS will not penalize you for doing so.

 

Timelines for 1031 Exchanges

Identifying your replacement properties and choosing your qualified intermediary is an excellent way to avoid a time crunch before beginning the 1031 process. To acquire a new property or to identify your new property as part of your 1031 exchange within 45 days of closing on the original property sale, the IRS provides you with 45 days.

When you have sold your old property, you must purchase one or more properties on your list within 180 days to complete your 1031 exchange. It is impossible to exchange more than three properties for more than 200% of your old property’s value. Property not on the 45-day list cannot be purchased as part of the exchange.

 

What Is The Timeframe For Identifying 1031 Exchanges?

  • Identifying or purchasing the new property or properties you plan to purchase has 45 days from the date you sell the old property.
  • Regardless of when you own your new property, you must do so within 180 days after the sale of your old property or by the deadline for filing your tax return for the year the old property is transferred.
  • Not 45 days plus 180 days, but 180 days on the exchange.

 

Does Converting a 1031 Exchange Property Make Sense?

Some situations might make sense for converting your 1031 property to your principal residence, even though it is a personal choice. You may be able to show the IRS that moving into your rental property and becoming your principal residence is suitable or necessary in certain life-altering circumstances, such as:

  • Losing your job unexpectedly
  • Disabilities
  • Divorce
  • Severe injury or health condition
  • Marriage
  • Adopting an elderly parent or loved one

Keeping any paperwork necessary to confirm the IRS’ justifiable exception is crucial if your situation fits one of these life-altering events. In these cases, you must prove that you purchased the property as an investment or rental property.

 

Consider the Conversion of a Primary Property into a Rental Property

Consider the conversion of a small three-unit multi-family property and a single-family house into rental properties.

 

Property with multiple units

  • You are renting out two of the three units of your triplex (3-unit property) and living in one of them:
  • Convert one primary residence unit to a 1031 rental property with a Section 121
  • Use Section 1031 for two rental units

 

A single-family residence

  • To convert a primary residence into a Section 1031, use Section 121
  • To replace the single-family house with another like-kind investment property, conduct a Section 1031 tax-deferred exchange.

 

Keep these rules in mind:

  • Before converting, you must have lived in your primary residence for at least two of the last five years.
  • If you file separately, you can exclude up to $250,000 in capital gains; if you file together, you can exclude up to $500,000.

 

Final thoughts – 1031 Exchange on Primary Residence

Performing a 1031 exchange on a primary residence converted to a rental apartment or vice versa is an excellent investment strategy, but it can also be challenging. This is why you must assemble your team of professional advisors from Attorney Real Estate Group.

With our 1031 exchange experience, we can guide you through everything from planning to closing. Our clients have deferred 100% of the federal capital gains taxes on triple-net lease properties in exchange for low-maintenance and costly rentals.

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